By Steve Bergsman

Why have a number of fund managers, plan sponsors and providers come off the bench to make a play for REITs?

Since the tech bubble burst and the subsequent turmoil in the stock market, a consistent flow of investors began moving their dollars into the real estate sector. Many of those chose real estate securities due to their strong dividends, diversification benefits and excellent returns. And for good reason, real estate was one of just a handful of fund categories that was up more than 18 percent year-to-date (as of mid-August), according to Morningstar Associates.

The popularity of the investment type has prompted a new wave of "REIT rookies" to offer a REIT option for the first time. On one hand, mutual fund managers have introduced a greater number of dedicated real estate mutual funds. Also, plan sponsors and plan providers have begun incorporating a real estate option into a greater number of 401(k) plans. (Editor's Note: For more on the exclusion of a REIT option in defined contribution plans, read "Undefined Contributions".)

As an example, this year the $900 million Alcon Laboratories' 401(k) retirement plan added two new asset classes, convertibles and REITs, to its Active Balanced Fund, one of seven investment options available to participants. The decision to make these additions was driven by a recommendation from the plan's investment consultant, says John H. Selzer, senior investment analyst for Alcon Laboratories, a producer of eye care products.

"We hadn't developed a model for REITs," Datta says. "We are quantitative investors and we had not spent the time with REITs earlier. I wish we had done the work earlier because over the last year we have added value through the inclusion of REITs."

"Adding REITs to the Active Balanced Fund is expected to bring diversification, provide an inflation hedge and to increase current income of the fund," Selzer says. The Active Balanced Fund now has a target allocation (of 10 percent) to REITs.

While Alcon and other REIT rookies grasped the unique attributes of REITs and jumped on the bandwagon, some other companies have overlooked their benefits to a portfolio.

"In the past, people lumped real estate and REITs in with other categories, such as commodities, emerging markets, etc. But now, the income you derive from real estate is too important," says Thomas Trotman, a veteran REIT portfolio manager who was most recently vice president and portfolio manager at Delaware Investments.

"Before the Nasdaq crash and the advent of the bear market, people didn't care if they were focused on diversification and they really knew little about REITs," Trotman adds. "There was tremendous over-valuation in other markets, but when prices started moving down, investors learned quickly that diversification should not be a vogue. It should be a constant."

Typically, most diversification was within the equity asset allocation, but now investors are looking at options that move contra-cyclically to equity and bonds or have different risk profiles, which is why hedge funds, along with real estate, have also risen in popularity. One of the areas that are growing, although still a small percentage of the total, are REIT allocations in the 401(k) community.

"What REITs do for the insurance company as a whole is that they bring yield to the table and it's important to match yield on invested assets to the liabilities on insurance company products." Levy says. "REITs also bring lower volatility and lower beta than the average equity holding, as well as diversification."

Sponsor Savvy

In January 2002, over a year after Verizon Communications Inc. was formed from the merger of GTE and Bell Atlantic, the new company rationalized its 401(k) plan and one of the changes was the introduction of a real estate fund option.

The idea was "to offer investment choices that allowed plan participants to diversify their 401(k) portfolio and assume a level of risk they were comfortable with," notes Gwen Sparks, a spokesperson for Verizon.

Like Verizon and Alcon Laboratories, another company deciding to add a real estate fund option to its 401(k) plan was Ibbotson Associates. However, its route to adding a real estate fund was slightly different.

Ibbotson, a leading authority on asset allocation, published a study in 2002 analyzing the impact of adding REITs to a wide selection of diversified portfolios from 1972 to 2001. The study showed that the inclusion of REITs boosted compound annual total returns by as much as 0.8 of a percentage point when compared with non-REIT portfolios.

Ibbotson, which was commissioned by the National Association of Real Estate Investment Trusts (NAREIT) to conduct the study and subsequent updates, found that a $10,000 investment in a non-REIT portfolio in 1992 with dividends reinvested would have grown to $25,940 by 2001. A portfolio of similar risk that included an allocation of 10 percent to REITs would have increased to $27,890 by the end of 2001. And a third portfolio, adjusted to include a 20 percent REIT allocation, would have returned $29,170, a gain of 12.5 percent—or more than $3,000 more than the non-REIT portfolio over the course of the decade.

Ibbotson, itself, was so intrigued by the results that it added a real estate mutual fund to its own 401(k), says Alexa Auerbach, Ibbotson's public relations director.

Without giving specific details, Auerbach adds, "it was well-received and a lot of participants have added it to their portfolios."

"Investors who are saving for retirement through 401(k) and 403(b) plans, by definition, are long-term investors. If they do not have exposure to real estate they are missing out," Duffy says. "If you add exposure to real estate at 10 percent or 15 percent levels to a portfolio that is made up of stocks and bonds, you get a higher return for a given amount of risk or volatility."

REIT Fund-amentals

Helping facilitate plan sponsors' transition to including a REIT option has been a greater understanding of the sector from a wider range of fund managers. This has led to an increased number of REIT funds to choose from. NAREIT counts more than 70 dedicated real estate mutual funds.

One of the newest funds comes from Barclays Global Investors of San Francisco, which launched its fund for defined contribution investors in May. The fund already holds assets of $145 million. After three months, the fund delivered a 13.3 percent return, as compared with the benchmark at 13.4 percent. "We don't take any active risk over the benchmark," Keagy says. "Our goal is to deliver benchmark performance and benchmark risk."

Barclays Global is no stranger to REITs, boasting more than $600 million in dedicated U.S. REIT portfolios and nearly $900 billion in total assets under management worldwide. Its domestic real estate offerings include a U.S. Real Estate Securities Index Fund for defined contribution plans which is benchmarked to the Wilshire Real Estate Securities Index; two exchange traded funds, a Dow Jones iShares Real Estate Fund and iShares Cohen & Steers Real Estate Fund; and the new BGI U.S. REIT Index Fund F which will be benchmarked to the Morgan Stanley REIT Index.

"We see a growing market for 401(k) participants who are looking for ways to diversify their retirement savings," notes James Keagy, client relationship officer with Barclays Global. "We see numerous advantages for investors interested in real estate besides diversification, such as intraday pricing and liquidity, alignment of interests with management, no special oversight required, public company reporting standards and low correlation with other asset classes."

The recent popularity of real estate mutual funds has spurred older funds to add REITs for the first time to their portfolios. Such is the case with Numeric Investors' n/i Small Cap Value Fund. Founded in 1989, Numeric has $5.1 billion in assets under management and manages the n/i numeric investors family of funds, institutional portfolios, limited partnerships and offshore funds. About mid-year 2002, the company's small cap value fund made its initial foray into REIT investing.

"We don't have any REIT specific funds, but we do have assets in various buckets such as large cap growth and small cap value strategies," says Arup Datta, a managing director at Numeric. "The main reason for us to look at REITs was that small cap value benchmarks hold a 10 percent position in REITs, but we had run our fund, which has a very successful track record, without having invested in REITs."

Numeric felt by adding REITs, it would bring the fund closer in form to its benchmark. Model-driven Numeric spent a lot of resources in early 2002 trying to figure out how to quantitatively invest in REITs. Then having done the research, Numeric finally became comfortable with the new investment sector.

"We hadn't developed a model for REITs," Datta says. "We are quantitative investors and we had not spent the time with REITs earlier. I wish we had done the work earlier because over the last year we have added value through the inclusion of REITs."

A sample of the real estate companies now in Numeric's small cap portfolio include General Growth Properties Inc. (NYSE: GGP), The Rouse Company (NYSE: RSE) and Trizec Properties, Inc. (NYSE: TRZ)

Since 10 percent of the benchmark (Russell 2000 Value Index) is in REITs and Numeric manages sector neutral portfolios, a subsequent alignment now means 10 percent of the fund is in REITs. Numeric's small cap portfolio holds assets valued at $370 million, with $37 million invested in REITs.

Providing a REIT Option

Despite positive data backing the benefits of REITs, there still seems to be some reluctance among plan providers adding real estate to their portfolio options. However, there are signs of change as some leading institutional defined contribution plan providers have reversed their course and incorporated a REIT option.

For example, New York Life Insurance Co. invests heavily in direct real estate, yet its wholly owned subsidiary, NYLIM Retirement Plan Services, which administers more than $8 billion in comprehensive defined contribution, defined benefit and deferred compensation plans, sponsors no REIT mutual funds for its clients. Until the recent run-up in real estate, there really have been few requests, says David Levy, a director and portfolio manager with New York Life Investment Management LLC (NYLIM), which oversees NYLIM Retirement Plan Services.

Since 1997, NYLIM has held an internal portfolio of $96 billion in assets (derived from insurance payments) that included an initial investment in REITs of $80 million or under 0.1 percent of the asset base at that time. The investment in REITs has grown to $550 million or 0.5 to 0.75 percent of the current asset base. While NYLIM does not offer a dedicated REIT fund, the NYLIM MainStay Growth Opportunities Fund made small investments in REITs as far back as 1998, but now views REITs as an important yield theme going forward.

"What REITs do for the insurance company as a whole is that they bring yield to the table and it's important to match yield on invested assets to the liabilities on insurance company products," Levy says. "REITs also bring lower volatility and lower beta than the average equity holding, as well as diversification. As an example, REITs have historically had a very low correlation to the Nasdaq."

In providing a comprehensive array of full-service retirement programs to defined benefit and defined contribution plan sponsors, the company offers a number of investment options including its family of over 20 MainStay Funds.

The firm's MainStay Growth Opportunities Fund, with $85 million in assets, invests primarily in equity securities of well- established, well-managed large and mid-size U.S. companies that appear to have better-than-average capital appreciation potential.

"REITs have returned to the portfolio and the reason for that is due to the direction of the overall market," Levy says. "There has been more interest in yield-oriented investments and a premium placed on lower-volatility investments. We resumed investing in REITs about the middle of 2002 and the inclusion has helped that fund because the yields and capital appreciation have been so good."

REITs will be a long-term investment for the fund, Levy says. "REIT fundamentals lagged stock performance to some extent over the three-year bull run in the sector, but that's largely due to the fact that inflows have been very strong to this group. On the other hand, REIT fundamentals will grow into the current stock prices over the long term," he says. "They have come through the trough of the cycle and now the economy is starting to improve."

Perhaps the most interesting examples of big institutional investors with a long history of real estate investing without offering a real estate mutual fund are TIAA-CREF and Principal Financial Group Inc.

Both TIAA-CREF and Principal accomplished something no other real estate investment manager or institutional investor has yet to do—the creation of funds (actually separate accounts) for defined contribution investors who want to invest directly in real estate. In essence, they each accomplished the hard part first. Both TIAA-CREF's and Principal's real estate separate accounts have been attracting investment dollars and producing solid returns since the mid-1990s.

Due to a number of factors, mostly the difficulty in achieving daily valuation and liquidity, hard asset real estate funds are difficult to establish for defined contribution plans, which is why some investment managers opt to sponsor funds that invest in publicly traded real estate companies such as REITs. TIAA-CREF and Principal tackled the harder job first and it wasn't until the last two years that they created a REIT mutual fund.

Principal's private real estate vehicle for 401(k) plans, now managed by the company's Principal Global Investors subsidiary, has grown to $1.5 billion in assets.

As with NYLIM Retirement Services, Principal is one of the largest administrators of defined contribution plans. Although five years ago it created a REIT fund for retail investors, it wasn't until 2003 that it added a fund to its 401(k) menu.

"What we have done in our pension business is create a platform of our REIT mutual fund for the retirement business, which is available to 401(k) clients and their participants," says Michael Finnegan, second vice president for retirement and investors' services at Principal Financial.

Part of the reason for the addition was demand caused by the attractiveness of REIT returns compared to other stocks, Finnegan says. Principal's REIT strategy on the retail side manages $48 million in assets, while the 401(k) component has already risen to $132 million.

Similarly, TIAA-CREF's real estate separate account was booming as well, climbing to $4 billion in assets since the founding of the fund back in 1995. Still, it didn't launch a real estate mutual fund until October 2002, seeded by $20 million of its own capital. The asset value of the fund in August stood at $130 million, and $5 million of the original $20 million seed has been given back to the company.

"Inflows have met or exceeded our goals," says Andy Duffy, a managing director for TIAA-CREF and a team leader for the real estate securities fund. "TIAA-CREF has a large number of existing relationships with about 15,000 post-secondary institutions where we manage their employee retirement programs in the 403(b) channel. With that large installed base, when you offer a new product like this there is a substantial level of potential interest."

TIAA-CREF's forecast for its relatively new REIT fund is that inflows will grow dramatically over the months to come.

"Investors who are saving for retirement through 401(k) and 403(b) plans, by definition, are long-term investors. If they do not have exposure to real estate they are missing out," Duffy says. "If you add exposure to real estate at 10 percent or 15 percent levels to a portfolio that is made up of stocks and bonds, you get a higher return for a given amount of risk or volatility."